What's Your Practice Worth?

When it comes to the financial analysis and valuation of law firms, there is only one certainty: Law firm founders and managing partners will always over-estimate the value of their firms. This is not surprising among business owners or anyone who has an equity stake in a company. No matter the industry, it comes down to human nature. These individuals devote a greater part of their waking hours to growing and building their business and, in many situations, its value to them cannot often be quantified or defined by dollar signs.

The over-estimation of value is especially true in professional services firms where the most prized assets ' the partners and other professional staff ' ride up and down in the office elevators each day. Ironically, this is also the reason why valuations are often lower than expected. Oftentimes it is much easier to value companies that manufacture or sell hard assets (i.e., products and equipment) than it is to value the goodwill of a law firm.

Law firms, because of caseload analysis and the project-oriented nature of their work, are notoriously hard to value, even more so than accounting firms and other professional service industries where there is an established schedule of work for at least a 12-month period. Ask 10 business valuation experts their opinion of a law firm's value, and you're likely to get 10 different answers. However, assuming the proper utilization of generally accepted appraisal standards, those answers should be somewhere in the same ballpark. Law firms may have little in the way of hard assets and may not be hired or engaged until needed. In addition, consider the fact that until relatively recent times, quantifying the value of long-standing and loyal law firm clients wasn't allowed, as courts had decided that clients could not be bought and sold or valued as “property.”

The only time managing partners can truly put their assumptions of firm value to the test is in a buy-sell scenario. In these cases, real-world value may exceed true value when a strategic or synergistic buyer is willing to pay a premium. Conversely, if partners are eager to sell, and the buyer knows it, the value of the firm could be much less than the true value.

Reasons to Undergo Business Valuations

There are many reasons for law firms to undergo business valuations that have little to do with real-world negotiations associated with the sale of a firm. These reasons are:

• a business divorce, or dissolution when dissenting partners split;
• a marital divorce, where the value of the firm is important in the division of assets;
• for estate planning and/or estate tax preparation purposes;
• when a partner retires from the firm/succession planning; or
• for value-enhancement planning and advanced planning for a possible or potential future sale of a firm.

In the current environment, a combination of law firm partners' divorces and the sales of firms fueled by fear of bankruptcy or dissolution are driving business valuations.

Divorce levels have decreased nationally because many middle- to-low income couples simply can't afford to split. Anecdotally, though, it seems that divorce is up among wealthier people, and attorneys. Economy-induced reductions in compensation, it appears, have put a strain on high-income and high-net-worth marriages. An ongoing good paycheck apparently makes law firm partners (male or female) much more palatable.

Another reason is law firm sales motivated by fear. Many smaller firms are seeking to partner with or merge into larger firms that have the depth and resources to survive economic downturns. Partners at smaller firms may be looking to merge as a lifeline, especially after reading about or experiencing recent bankruptcies at several firms. While it is not an ideal time to sell (in a down market), getting some value may be better than no value at all.

While partners involved in the sale or merger of a law firm will do their best to argue for the highest valuation, a fellow partner at the same firm ' involved in a messy and expensive divorce ' may be arguing that his or her firm has little value. In either case, valuation experts should approach each engagement in a neutral fashion. Unlike sports or real estate agents who are paid to get the most value, it's unethical for valuation experts to work toward pushing a valuation in one direction or another, based on who's paying them.

No Simple Formula

So how much is your law firm worth? Better yet, because there are so many variables, how is a law firm's value determined? It's wishful thinking to believe a simple formula exists in which a standard multiple can be applied to either gross revenues or net income. If that were the case, business valuation professionals wouldn't have so many letters, certifications, and designations after their names. Ultimately, a law firm's worth might be derived in terms of a multiple, but determining whether that multiple is 1.2 or 3.8 is the real issue.

Despite the fact that some law firms might have plush office facilities with expensive artwork hanging on the walls, professional service firms ' and other businesses that usually have little in the way of hard assets ' are typically valued using an income approach, a market approach, or possibly a hybrid methodology when appropriate. The income approach is generally based on the present value of a projected or forecasted future revenue stream that a law firm is expected to generate, and takes into account several key factors that need to be considered in order to derive an opinion of value. Tangible factors are the financial assets and liabilities of a firm, including:

• Cash on hand;
• Investments;
• Accounts receivables;
• Accounts payable;
• Other debt;
• Gross revenues;
• Overhead expenses;
• Salaries and compensation; and
• Currently contracted work/projects or existing caseload.

These areas are easy to determine and document, but may not go very far in determining the true value of a law firm. They fail to account for much of what is known as goodwill, including long-standing client relationships (the likelihood that clients will return to the firm for services), a record of accomplishment, and a history of billings that implies and reflects strong year-over-year revenues. Many law firm partners over-estimate this goodwill, and neglect to factor in the risks associated with pending or uncontracted client workload, and the potential negative risk aspects of partners or other attorneys and associates who maintain close client relationships.

A law firm may have a long and distinguished history and may be a top firm nationally, regionally, statewide, or even locally. While there is value in that, it's not as important as a firm's current revenues, potential future revenues, and the firm's current state of affairs. The 50-year-old law firm that has experienced choppy revenues over the last five years or so can expect the value of its “goodwill” to be discounted. The following is a list of some tangible and intangible factors, much of which, but not all, fall under the category of goodwill and can provide some quick insight into implications for overall value. There are two types of goodwill: practice goodwill, which is attributable to the firm, and personal goodwill, which is associated with an individual attorney or attorneys.

• The history and reputation of the firm: A strong history and reputation adds value in that there is an assumption that ongoing business will be gained through word-of-mouth and referrals. It might also be reasonable to expect that certain clients will pay at least a little extra to work with a specific firm, a partner, or partners of that firm.
• Capital structure of the firm: A strong balance sheet and significant net worth certainly provide added hard asset value to a firm, but might also enhance the overall goodwill aspects of a firm as well.
• Intellectual or human capital amassed by the firm: Strong experience and expertise in a specific area, industry or niche, such as litigation, contract law, bankruptcy, or real estate, is included here.
• Expected work via forecast or projections by management: Based on firm revenues and individual client billing patterns from the past several years ' and an analysis of the issues and challenges facing existing clients ' it is possible to project a future income stream.
• The success rate of the firm: Especially if a firm handles a great deal of litigation, the firm's recent “record,” or the firm's historical “win ratio” may prove to be an important indicator of its future success, at least in the short term.
• Number of long-standing clients: The more a firm maintains long-standing clients and repeat business, the better for a firm's value.
• Number of clients that have work spread across different partners and practices at the firm: The more, the better, as it indicates a firm that can cross-sell its practice areas and has a strong, multi-partner relationship with its existing and potential client base.
• Rate at which a firm retains its clientele: If there are a good number of clients that have hired a law firm, but then subsequently leave for other firms, this could raise a red flag for a subject firm's valuation.
• Partners' future earning ability: Younger partners create higher future value for a firm since they have a greater future earning ability, i.e., their work-life expectancy is longer. Older partners can create value in other ways, such as reputation, affiliations, experience, and the wisdom that comes with age.
• The types of clients: A law firm based in Silicon Valley in 2000 was rolling in dough, but not well positioned by 2002, by which time the Internet bubble was fully deflated. Long-standing and well-established companies (think Fortune 500) provide for the highest potential value.

Enhancing Value

If a law firm requires a valuation post-haste, there's little to nothing that can be done that might serve to improve the value of the firm in the short term. However, if the partners know a sale or merger is planned for some point down the road, they can begin to enhance their firm's value in several ways, including:

• Convert personal goodwill into practice goodwill: Leverage the expertise or celebrity value of one or more attorneys to enhance the image of the entire firm. This means the encouragement of a “team” approach to client work.
• Don't allow one attorney to monopolize a client: There's greater risk if one partner fully controls the relationship with one or more major clients. Aside from the management reasons, a client will receive better service from a team of attorneys, and should be aware of who is working on its behalf.
• Create intellectual capital through the creation of knowledge-management systems. These systems, which can be as simple as databases, help to ensure that knowledge, experience, and expertise are shared among a firm's attorneys. The systems help lessen the potential loss, should an attorney or small group of attorneys leave a firm with institutional knowledge.
• Create practice goodwill through firm-wide branding and promotion. A firm may be doing well financially, despite a low public profile. However, an enhanced public image, promoting the expertise of the firm and its successful client engagements, will not only help drive additional business, but will also position the firm's image as a respected and high-quality firm over time.

The Market Approach

This article has not spent much time discussing the market approach to valuation. Using this approach, a law firm valuation is based on an analysis of similarly situated firms, which were sold or acquired within a set time frame. Looking at the selling price of comparative firms provides insight and a good indication of potential market value. As you might imagine, it's often difficult to find “similarly situated” firms that recently sold, especially when you consider all the variables that go into categorizing law firms. Of course, specific firm adjustments should always be considered when employing the market approach in the valuation process. Quality-oriented valuation methodology should always include consideration of the market approach in addition to an income approach.

Once comparisons are found, those sales are analyzed to determine what multiples of revenue and/or net income were used, and then a mean or median might be applied to the subject law firm under analysis.

Conclusion

There are many other aspects to the valuation process (such as the application of discounts and premiums) that are beyond the scope of this article. Generally, the quantification of a firm's worth is like an appraisal picture or snapshot of value at a given point in time, which for estate purposes is standard procedure. However, the value of an ongoing concern is a living, breathing, ever-changing aspect and, when a firm is seeking valuation for future planning or value-enhancement purposes, it may be more appropriate to ask for a range of values in order to properly capture the view.

Edward D. Heben, CPA/ABV/CFF, CVA, AEP, is a partner in the Valuation and Forensic Services division of the accounting and consulting firm Citrin Cooperman & Company, LLP and has more than 35 years of experience providing services to small, medium, and large sized law firms and other types of businesses. He can be contacted at [email protected] or 914-949-2990 ext. 356.

When it comes to the financial analysis and valuation of law firms, there is only one certainty: Law firm founders and managing partners will always over-estimate the value of their firms. This is not surprising among business owners or anyone who has an equity stake in a company. No matter the industry, it comes down to human nature. These individuals devote a greater part of their waking hours to growing and building their business and, in many situations, its value to them cannot often be quantified or defined by dollar signs.

The over-estimation of value is especially true in professional services firms where the most prized assets ' the partners and other professional staff ' ride up and down in the office elevators each day. Ironically, this is also the reason why valuations are often lower than expected. Oftentimes it is much easier to value companies that manufacture or sell hard assets (i.e., products and equipment) than it is to value the goodwill of a law firm.

Law firms, because of caseload analysis and the project-oriented nature of their work, are notoriously hard to value, even more so than accounting firms and other professional service industries where there is an established schedule of work for at least a 12-month period. Ask 10 business valuation experts their opinion of a law firm's value, and you're likely to get 10 different answers. However, assuming the proper utilization of generally accepted appraisal standards, those answers should be somewhere in the same ballpark. Law firms may have little in the way of hard assets and may not be hired or engaged until needed. In addition, consider the fact that until relatively recent times, quantifying the value of long-standing and loyal law firm clients wasn't allowed, as courts had decided that clients could not be bought and sold or valued as “property.”

The only time managing partners can truly put their assumptions of firm value to the test is in a buy-sell scenario. In these cases, real-world value may exceed true value when a strategic or synergistic buyer is willing to pay a premium. Conversely, if partners are eager to sell, and the buyer knows it, the value of the firm could be much less than the true value.

Reasons to Undergo Business Valuations

There are many reasons for law firms to undergo business valuations that have little to do with real-world negotiations associated with the sale of a firm. These reasons are:

• a business divorce, or dissolution when dissenting partners split;
• a marital divorce, where the value of the firm is important in the division of assets;
• for estate planning and/or estate tax preparation purposes;
• when a partner retires from the firm/succession planning; or
• for value-enhancement planning and advanced planning for a possible or potential future sale of a firm.

In the current environment, a combination of law firm partners' divorces and the sales of firms fueled by fear of bankruptcy or dissolution are driving business valuations.

Divorce levels have decreased nationally because many middle- to-low income couples simply can't afford to split. Anecdotally, though, it seems that divorce is up among wealthier people, and attorneys. Economy-induced reductions in compensation, it appears, have put a strain on high-income and high-net-worth marriages. An ongoing good paycheck apparently makes law firm partners (male or female) much more palatable.

Another reason is law firm sales motivated by fear. Many smaller firms are seeking to partner with or merge into larger firms that have the depth and resources to survive economic downturns. Partners at smaller firms may be looking to merge as a lifeline, especially after reading about or experiencing recent bankruptcies at several firms. While it is not an ideal time to sell (in a down market), getting some value may be better than no value at all.

While partners involved in the sale or merger of a law firm will do their best to argue for the highest valuation, a fellow partner at the same firm ' involved in a messy and expensive divorce ' may be arguing that his or her firm has little value. In either case, valuation experts should approach each engagement in a neutral fashion. Unlike sports or real estate agents who are paid to get the most value, it's unethical for valuation experts to work toward pushing a valuation in one direction or another, based on who's paying them.

No Simple Formula

So how much is your law firm worth? Better yet, because there are so many variables, how is a law firm's value determined? It's wishful thinking to believe a simple formula exists in which a standard multiple can be applied to either gross revenues or net income. If that were the case, business valuation professionals wouldn't have so many letters, certifications, and designations after their names. Ultimately, a law firm's worth might be derived in terms of a multiple, but determining whether that multiple is 1.2 or 3.8 is the real issue.

Despite the fact that some law firms might have plush office facilities with expensive artwork hanging on the walls, professional service firms ' and other businesses that usually have little in the way of hard assets ' are typically valued using an income approach, a market approach, or possibly a hybrid methodology when appropriate. The income approach is generally based on the present value of a projected or forecasted future revenue stream that a law firm is expected to generate, and takes into account several key factors that need to be considered in order to derive an opinion of value. Tangible factors are the financial assets and liabilities of a firm, including:

• Cash on hand;
• Investments;
• Accounts receivables;
• Accounts payable;
• Other debt;
• Gross revenues;
• Overhead expenses;
• Salaries and compensation; and
• Currently contracted work/projects or existing caseload.

These areas are easy to determine and document, but may not go very far in determining the true value of a law firm. They fail to account for much of what is known as goodwill, including long-standing client relationships (the likelihood that clients will return to the firm for services), a record of accomplishment, and a history of billings that implies and reflects strong year-over-year revenues. Many law firm partners over-estimate this goodwill, and neglect to factor in the risks associated with pending or uncontracted client workload, and the potential negative risk aspects of partners or other attorneys and associates who maintain close client relationships.

A law firm may have a long and distinguished history and may be a top firm nationally, regionally, statewide, or even locally. While there is value in that, it's not as important as a firm's current revenues, potential future revenues, and the firm's current state of affairs. The 50-year-old law firm that has experienced choppy revenues over the last five years or so can expect the value of its “goodwill” to be discounted. The following is a list of some tangible and intangible factors, much of which, but not all, fall under the category of goodwill and can provide some quick insight into implications for overall value. There are two types of goodwill: practice goodwill, which is attributable to the firm, and personal goodwill, which is associated with an individual attorney or attorneys.

• The history and reputation of the firm: A strong history and reputation adds value in that there is an assumption that ongoing business will be gained through word-of-mouth and referrals. It might also be reasonable to expect that certain clients will pay at least a little extra to work with a specific firm, a partner, or partners of that firm.
• Capital structure of the firm: A strong balance sheet and significant net worth certainly provide added hard asset value to a firm, but might also enhance the overall goodwill aspects of a firm as well.
• Intellectual or human capital amassed by the firm: Strong experience and expertise in a specific area, industry or niche, such as litigation, contract law, bankruptcy, or real estate, is included here.
• Expected work via forecast or projections by management: Based on firm revenues and individual client billing patterns from the past several years ' and an analysis of the issues and challenges facing existing clients ' it is possible to project a future income stream.
• The success rate of the firm: Especially if a firm handles a great deal of litigation, the firm's recent “record,” or the firm's historical “win ratio” may prove to be an important indicator of its future success, at least in the short term.
• Number of long-standing clients: The more a firm maintains long-standing clients and repeat business, the better for a firm's value.
• Number of clients that have work spread across different partners and practices at the firm: The more, the better, as it indicates a firm that can cross-sell its practice areas and has a strong, multi-partner relationship with its existing and potential client base.
• Rate at which a firm retains its clientele: If there are a good number of clients that have hired a law firm, but then subsequently leave for other firms, this could raise a red flag for a subject firm's valuation.
• Partners' future earning ability: Younger partners create higher future value for a firm since they have a greater future earning ability, i.e., their work-life expectancy is longer. Older partners can create value in other ways, such as reputation, affiliations, experience, and the wisdom that comes with age.
• The types of clients: A law firm based in Silicon Valley in 2000 was rolling in dough, but not well positioned by 2002, by which time the Internet bubble was fully deflated. Long-standing and well-established companies (think Fortune 500) provide for the highest potential value.

Enhancing Value

If a law firm requires a valuation post-haste, there's little to nothing that can be done that might serve to improve the value of the firm in the short term. However, if the partners know a sale or merger is planned for some point down the road, they can begin to enhance their firm's value in several ways, including:

• Convert personal goodwill into practice goodwill: Leverage the expertise or celebrity value of one or more attorneys to enhance the image of the entire firm. This means the encouragement of a “team” approach to client work.
• Don't allow one attorney to monopolize a client: There's greater risk if one partner fully controls the relationship with one or more major clients. Aside from the management reasons, a client will receive better service from a team of attorneys, and should be aware of who is working on its behalf.
• Create intellectual capital through the creation of knowledge-management systems. These systems, which can be as simple as databases, help to ensure that knowledge, experience, and expertise are shared among a firm's attorneys. The systems help lessen the potential loss, should an attorney or small group of attorneys leave a firm with institutional knowledge.
• Create practice goodwill through firm-wide branding and promotion. A firm may be doing well financially, despite a low public profile. However, an enhanced public image, promoting the expertise of the firm and its successful client engagements, will not only help drive additional business, but will also position the firm's image as a respected and high-quality firm over time.

The Market Approach

This article has not spent much time discussing the market approach to valuation. Using this approach, a law firm valuation is based on an analysis of similarly situated firms, which were sold or acquired within a set time frame. Looking at the selling price of comparative firms provides insight and a good indication of potential market value. As you might imagine, it's often difficult to find “similarly situated” firms that recently sold, especially when you consider all the variables that go into categorizing law firms. Of course, specific firm adjustments should always be considered when employing the market approach in the valuation process. Quality-oriented valuation methodology should always include consideration of the market approach in addition to an income approach.

Once comparisons are found, those sales are analyzed to determine what multiples of revenue and/or net income were used, and then a mean or median might be applied to the subject law firm under analysis.

Conclusion

There are many other aspects to the valuation process (such as the application of discounts and premiums) that are beyond the scope of this article. Generally, the quantification of a firm's worth is like an appraisal picture or snapshot of value at a given point in time, which for estate purposes is standard procedure. However, the value of an ongoing concern is a living, breathing, ever-changing aspect and, when a firm is seeking valuation for future planning or value-enhancement purposes, it may be more appropriate to ask for a range of values in order to properly capture the view.

Edward D. Heben, CPA/ABV/CFF, CVA, AEP, is a partner in the Valuation and Forensic Services division of the accounting and consulting firm Citrin Cooperman & Company, LLP and has more than 35 years of experience providing services to small, medium, and large sized law firms and other types of businesses. He can be contacted at [email protected] or 914-949-2990 ext. 356.